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Discussion topics
Time Value of Money
Present Value of a single cash flow
Present Value of multiple cash flows
Annuity
Perpetuity
Analysis of Loan
Capital Budgeting
Capital Budgeting Evaluation Process
Payback period (PB)
Discounted payback period (DPB)
Net present value (NPV)
Internal rate of return (IRR)
Profitability Index (PI)
To sum up..
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Time Value of Money
When we say that money has time value, we mean that a dollar today is worth more than a
dollar next year.
If you have a dollar today, you can earn interest on it and have more than a dollar next year
Present Value of a single cash flow
Present Value of multiple cash flows
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Time Value of Money

Principle of Financial Equivalence
We know the future value of US$200 at the end of two years, at 10% annual interest is US$242. What
does this mean?
If the interest rate in the economy was 10% and ignore risk, which one will you select?
Answer will be indifferent?
Frequency of compounding
Yearly / Quarterly / Monthly compounding
Continuous compounding
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Time Value of Money .. contd
Annuity
An Annuity is a bunch of structured payments or equal payments made regularly, like every month or
every year
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Lump sum
payment
?
US$50,000
per year
for the
next 22
years
You won a
lottery worth
US$1,000,000
Which one will
you select?
Time Value of Money .. contd
Perpetuity
A perpetuity is a special kind of annuity - it has an infinite number of cash flows, all of the same dollar
amount. Thus, it is an annuity that never ends!
Will you choose to receive an annual payment of US$30,000 forever instead of the Lump sum payment?
Analysis of Loan (worksheet Time Value of Money)
Suppose you take a loan of Rs1.5mn from ICICI Bank for doing your MBA from IIM Ahmedabad. Term of
the loan is 5 years. What is the monthly payment that you will need to make?
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Introduction to Capital Budgeting
Capital budgeting is an investment decision-making process to evaluate whether a project is
worth undertaking
Capital budgeting is basically concerned with the justification of capital expenditures
What is the overall aim of capital budgeting?
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Maximize
Shareholders Wealth
Capital
Budgeting
A Strategic investment decision
Large investment with returns
over a period of time
Investment may take place over
a period of time
Motivation
Replacement
Expansion
Modernization
R&D
Most
important?
Location
Infrastructure
Labor
Cash flows
Capital Budgeting Evaluation Tools
Capital budgeting evaluation tools
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Capital
Budgeting
Tools
Payback
period
Discount
payback
period
Net
present
value
Internal
rate of
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Modified
internal
Rate of
return
Profit
Index
Eq.
Annual
Cost
Best
Method?
Capital Budgeting Evaluation Tools
What provides a good decision making?
Decision rule should be based upon cash flow
Should discount cash flows appropriately taking into account the time value of money
Opportunity cost of capital should take into account the risk inherent in the project
Should incorporate all the incremental cash flows attributable to the project
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Capital Budgeting - Payback period
Payback period is defined as the number of years before the cumulative cash inflows equal
the initial outlay
Provides a rough idea of how long invested capital is at risk
Calculating payback period
Payback rule ignores all cash flows after the cutoff date
Payback rule gives equal weight to all cash flows before the cutoff date
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Capital Budgeting - Payback period
Decision rule
Payback benchmark payback, Accept the project
Payback benchmark payback, Reject the project
Calculate the payback period for Project A and Project B
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year the during flow cash
t ered unre year beginning
erery re full years period Payback
_ _ _ _
cos _ cov _ _
cov _ _ _

Years (t) Project A Project B

0 (3,000) (2,000)
1 1,800 200
2 1,000 600
3 800 1,000
4 200 2,000
Capital Budgeting - Payback period .. contd
Calculate the cumulative net cash flow (NCF) at the end of each time period.
Payback will occur when the cumulative NCF equal zero
Payback period A = 2 + (200/800) = 2.25 years
Payback period B = 3 + (200/2000) = 3.10 years
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Years (t) year 0 year 1 year 2 year 3 year 4
Project A Net cash flow (3,000) 1,800 1,000 800 200
Cumulative NCF (3,000) (1,200) (200) 600 800
Project B Net cash flow (2,000) 200 600 1,000 2,000
Cumulative NCF (2,000) (1,800) (1,200) (200) 1,800
Capital Budgeting - Payback period .. contd
Discounted payback period
Drawback of the previous method is that it ignores time value of money
Use discounted cash flows rather than raw cash flows
Example: In the previous question use 10% as the discount rate
Payback period A and B increases to 2.89years and 3.41years, respectively
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Years (t) year 0 year 1 year 2 year 3 year 4
Project A Net cash flow (3,000) 1,800 1,000 800 200
Discounted NCF (3,000) 1,636 826 601 137
Cumulative DNCF (3,000) (1,364) (537) 64 200
Project B Net cash flow (2,000) 200 600 1,000 2,000
Cumulative NCF (2,000) 182 496 751 1,366
Cumulative DNCF (2,000) (1,818) (1,322) (571) 795
Capital Budgeting - Net present value (NPV)
Three points to remember about NPV
A dollar today is worth more than the dollar tomorrow
A safe dollar is worth more than a risky one
We can add present value of all individual cash flows of the project
Sum of the PVs of all cash inflows and outflows of a project
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Capital Budgeting - Net present value (NPV)

Also NPV is defined as present value of incremental benefits LESS present value of
incremental costs
In the example used for payback, calculate the NPV of Project A and Project B
Which project should be selected when (1) Both projects are independent (2) Mutually Exclusive
Independent projects: Accept if NPV>0; Both project A and project B should be selected
Mutually exclusive projects: Choose the one with higher NPV, as long as NPV>0; Project B
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Years (t) year 0 year 1 year 2 year 3 year 4
Project A Net cash flow (3,000) 1,800 1,000 800 200
Discounted NCF (3,000) 1,636 826 601 137
NPV 200
Project B Net cash flow (2,000) 200 600 1,000 2,000
Cumulative NCF (2,000) 182 496 751 1,366
NPV 795
Capital Budgeting - Internal rate of return (IRR)
Defined as the rate of return that equates the present value of the projects estimated cash
inflows with the present value of the projects costs
PV (inflows) = project cost in present value terms
Also defined as the discount rate that sets the NPV of a project to zero is the projects IRR
To calculate the IRR, we may use the trial-and-error method
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Capital Budgeting - Internal rate of return (IRR)

IRR Acceptance Criteria
Independent Projects: IRR > Cost of Capital (hurdle rate), accept the project
Independent Projects: IRR < Cost of Capital (hurdle rate), reject the project
Mutually Exclusive Project, rank all projects for which IRR hurdle rate
Continuing with our earlier example, compute the IRR for Project A and Project B
Recommend acceptance under the assumption that projects are (1) independent (2) mutually exclusive
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IRR (Project A) = 14.1%
IRR (Project B) = 22.4%
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Capital Budgeting Profitability Index
When funds are limited, we must pick the project that offer the highest net present value per
dollar of initial outlay Profitability Index
Calculation of Profitability Index
Which of the following will you select if you have a budget of US$12mn
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NPV
PI

Project Year 0 Year 1 Year 2 NPV @ 10% Profitability Index

A (12) 30 5 18 1.5
B (7) 5 20 13 1.8
C (5) 5 15 11 2.2
Capital Budgeting Profitability Index
PI and NPV can give conflicting signals when a firm is choosing between projects
Which of the following will be selected if the firm can raise only US$12mn for investment
each of Year 0 and Year 1
Profitability Index cannot cope with cases in which two projects are mutually exclusive or in
which one project is dependent on another
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Project Year 0 Year 1 Year 2 NPV @ 10% Profitability Index
A (12) 30 5 18 1.5
B (7) 5 20 13 1.8
C (5) 5 15 11 2.2
D (35) 50 10 0.3